Competition and innovation: Evidence from financial services

This paper presents new evidence on the relationship between competition and innovation by extending previous literature from manufacturing to financial services. We introduce a new measure of overall innovation by estimating and enveloping annual minimum cost frontiers to create a global frontier. The distance to the global frontier constitutes each bank's technology gap, which decreases if the bank manages to innovate. Our innovation measure enables us to derive and estimate the model of Aghion et al. (2005b) at the firm level for the US banking industry. Based on individual bank Call Report data for the period 1984-2004, consistent with theoretical and empirical work by Aghion et al., we find evidence of an inverted-U relationship between competition and innovation that is robust over several different specifications. Further evidence on major structural changes in the US banking industry indicates that banks moved beyond their optimal innovation level and that interstate banking deregulation resulted in lower bank innovation. Policy implications to financial reform and prudential regulation are discussed also. (C) 2013 Elsevier B.V. All rights reserved.